European Capital Markets: Efficient . . . but Resilient?

The goal of the capital markets union is to make European financial market integration more efficient. Firms will be able to gain access to international credit (and other forms of capital) directly from the market rather than having to rely on banks for intermediation; savers will be able to gain access to cross-border investment opportunities without facing high transaction costs.

In principle, this is a win-win situation for the single European market that should give a boost to European financial market reintegration after the most recent (iteration of the) crisis. It will also reduce the systemic importance of European financial institutions, which should make them easier to regulate and discipline. And it will complement efforts to create a Europe-wide system for payment and settlement as spearheaded by the European Central Bank (ECB).

Importantly, none of this activity is limited to transactions within the single currency. Both the capital markets union and the more technical project developed by the ECB are for Europe as a whole and not just those countries that use the euro. This is an important break with the past. The original real-time gross transfer and settlement mechanism (Target) and its successor (Target2) both focused on euro-denominated transactions; non-euro central banks could gain access to the system, but they had to settle their accounts by the end of the trading day.

This two-tier structure no longer exists in the new paradigm. The latest arrangement, called ‘Target2 for Securities’ or T2S, makes it possible to use central bank liquidity to settle cross-border securities transactions in multiple currencies. As ECB Executive Board Member Yves Mersch explained recently to an audience in Singapore, there is no reason why future iterations of the original Target system for financial transactions could not also expand payment and settlement activity beyond the euro area. In an ideal world, such improvements in European financial market infrastructure would take place alongside the development of a truly pan-European system for collateral management.

It is easy to see how this combination of features – a capital markets union coupled with overlapping European payment, settlement, and collateral management arrangements – would make European financial markets more efficient. As more and more market infrastructures (exchanges, clearing houses, depositories, etc.) adapt their business models to the new environment, firms should find easier and cheaper access to capital even as savers garner a higher return on their investments; meanwhile, everyone should benefit from an increased diversification in cross-border exposure and a greater sharing of cross-border risk.

The question is whether this system will be resilient. Here it is not useful to think about the usual ups and downs of market performance or even the creative destruction that dominates the lives of firms. A broader, deeper, and more diversified financial marketplace will be better able to handle such turbulence. That is a big part of the efficiency gains that the ever deeper integration of European financial markets represents.

The real challenge will come from any shock that triggers a sudden (re-)disintegration of European financial markets as market participants seek to liquidate their cross-border exposures in order to protect the principal of their investments. This is the dynamic that defined Europe’s response to the recent crisis; it explains both the sudden evacuation of liquidity from the European periphery and negative real rates of return on savings that now afflict the countries at Europe’s core. European investors are less interested in the attractions of an internationally diversified portfolio and so are willing to pay the governments of countries like Germany, Denmark, Sweden and Switzerland to safeguard their capital.

A more efficient European financial marketplace will facilitate such flights to safety in times of crisis – making it easier for market participants to express their fear. This is likely to strain both key market infrastructures and any Europe-wide collateral management system. The only way to address those strains will be to provide any equally pan-European response in the form of lender of last resort facilities, resolution funding, collateral waivers and the like.

Unfortunately, these are precisely the areas where European leaders show the greatest reluctance to cooperate. That is what recent experience with the European banking union project reveals. Europe’s heads of state and government are happy to share the benefits of a more efficient marketplace and yet wary of sharing out the burdens that true market resilience requires. This imbalance in European commitment is more than unfortunate. The most recent crisis has tested European solidarity to the limits. A more dramatic crisis – lubricated by more efficient cross-border financial market institutions – could make matters even worse.

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[…] supplement the efforts to make capital markets more efficient with efforts to make them more resilient. This is an argument that I have made before and yet it is probably worth repeating. Given the […]